Today’s post is from Adrian Blundell-Wignall and builds on his OECD working paper The Bitcoin Question: Currency versus Trust-less Transfer Technology. The views expressed here are his own and do not necessarily reflect those of the OECD or of its member countries.
The working paper argues that some of the technologies associated with crypto-currencies are very interesting and may one day become a serious disruptive technology for financial intermediaries—but that these technologies should be thought about separately from the crypto-currencies like Bitcoin that have some very dubious uses. These coins, the paper argues, can never replace legal tender like dollars. However, some Bitcoin proponents seem to be very confused about the place crypto-currencies occupy versus legal tender. Referring to the working paper, one such author [Why the OECD Needs to do its Homework on Bitcoin] states:
“The author fundamentally views bitcoin as something that must replace legal tender in order to be successful, so he is dismissive of bitcoin the monetary unit. Moreover, the author fears bitcoin more as a competitive alternative within a freedom-of-choice scenario and thus outlines policy behavior that attempts to extinguish any interface with established institutions.”
This is pretty close to the opposite of what the working paper says. Neither Bitcoin nor any other crypto-currency can ever replace legal tender no matter how successful it is on any other criteria. Bitcoins are a parallel currency; i.e. adjacent to and not intersecting with legal tender. The author doesn’t “fear Bitcoin as a competitive alternative” to legal tender. It is impossible for Bitcoins to compete with legal tender as an alternative monetary system because the central bank has a very special monopoly that is impossible to attack – in the limit because people have to pay their taxes. The policy conclusions with respect to the crypto-currency have nothing whatever to do with fear of Bitcoin replacing legal tender—that can’t happen—and have everything to do with money transmission that bypasses surveillance for certain purposes before coming happily back into the legal tender system afterwards (with neither tax, criminal or regulatory authorities able to follow the money trail in between).
Some Bitcoin proponents are very frightened of the idea of bans on the interface of crypto-currencies with exchangers whose banks participate in the central bank’s clearing system. The author of the above quote talks combatively about the free world taking on the monopoly of legal tender and how they just might jolly-well have to create alternative clearing systems to win the battle. This completely misunderstands the basics of the clearing system that the central bank participates in—i.e. the central bank that creates the currency in which Bitcoin prices are quoted and that the traders of crypto-currencies want wisely to be able to get back into when done trading.
Let’s explain it in simple terms. Banks must settle between themselves and the central bank in what is deemed by the authorities to be ‘cash’—and that cash is always the central bank’s own liabilities (currency and bank reserves with the central bank). Mr. Smith writes a cheque on his ABC bank to Mr. Jones who banks with XYZ bank. ABC bank can transfer $1000 to XYZ which accepts ABC liabilities. Now suppose Mr. Smith writes a cheque to the government to pay his taxes. The government’s bank is the central bank and the essence of the monopoly is this—the central bank doesn’t accept ABC bank liabilities to settle—it will only accept its own liabilities. So if ABC bank has excess reserves at the central bank, then it can run them down. If it doesn’t have excess reserves it can borrow another bank’s excess reserves at the overnight interest rate. If it can’t do that it must borrow from the central bank itself at the overnight cash rate (like the Fed Funds rate).
The same issue arises if ABC bank wants to buy from or sell government bonds to the central bank—it is dealing with the central bank that only accepts its own liabilities. With this monopoly the central bank can make interest rates whatever it likes—for example, by buying and selling government bonds to increase or decrease the amount of cash in the system (offsetting the impact of tax payments and any other unwanted influences on cash). If the central bank wishes to change the stance of monetary policy, it changes the cash base of the system: if it creates more cash compared to the demand for it, interest rates can be induced to fall and vice versa. Bitcoins don’t and can’t matter.
Now let’s suppose Mr. Smith wishes to go into the Bitcoin world. He might debit his dollar bank account in favour of an exchanger who provides Bitcoins at the going exchange rate. He then begins transmitting Bitcoins in a series of transactions to do whatever it is he does in that anonymous parallel currency world. But then comes the day that Mr. Jones has to pay his taxes to the government or deal with other transactions involving the banking system with its pesky need to clear with other banks including the central bank. But the central bank doesn’t accept Bitcoins. It accepts its own liabilities. So the erstwhile crypto-currency adherent has to come back to the exchanger, cross the fee/spread, and get back into the banking system. Buying and selling Bitcoins affects only the exchange rate of dollars for Bitcoins with the exchangers, in the same way that dealing in bottles of wine on an internet wine exchange drives the price via supply and demand. The prices of bottles of wine and Bitcoins go up and down, but the dollar price fluctuations in Bitcoins and bottles of wine can never affect the determination of interest rates, where the central bank with its monopoly over cash runs the show. But rest assured, every Bitcoin user down to the last one will very much want to be able to get back into dollars at some point. Little wonder that some people in the industry want to fend off regulations: all in the name of freedom of choice of course.
But what are some of these in-and-out Bitcoin activities in the name of freedom? The original working paper notes that there is a speculative and transactions demand for Bitcoins. On the speculative demand there are the founders who need to be able to extract value at some advantageous point, and others who participate in the ‘greater fool’ trading strategy believing they will get out ahead of the other ‘fools’ in the market if prices tumble.
With regard to the transactions demand, it seems unlikely that the crypto-currencies are in general use to buy the weekly groceries because their use might be cheaper than credit and debit cards. This is because the transactions fee/spreads with exchangers must be high to compensate for all the volatility and regulatory risk, and holding the crypto-currency carries the risk of capital loss.
There is a clear demand on the part of some individuals, however, who are happy to cross the spreads with exchangers and those offering ‘darkening services’ as a price to pay for anonymity (darknets and mixers expressly designed to further enhance the anonymity features of Bitcoin). Who might some of these people be who operate in complex cross-border structures, often in countries with little or no surveillance of or laws concerning Bitcoins? Businesses using virtual coins that pass through complex structures and ‘darkening’ procedures, trade on the Internet and from mobile phones anonymously are impossible to trace. Such businesses do this presumably because they need to be anonymous. Then, when their untraceable business dealings are all done, the crypto-coins can then re-emerge in a new ‘legitimate’ transaction. For example, a real estate company decides to accept Bitcoins in Australia. The name of a ‘clean’ individual or company appears on the deed of a beautiful property overlooking Sydney harbor.
It is very unclear in the global digital world as to who should or can be responsible for monitoring crypto-currencies and in which jurisdictions—but someone should; and if the technology is such that all users can’t be registered and identified, then more serious policy action should presumably follow. Dealing with things like terrorism, drugs, arms trading, and people smuggling, as well as preventing the evasion of taxes, are all very essential in a civil society. Were ‘freedom of choice’ to facilitate such activities then that ‘freedom’ moves into direct conflict with the notion of a civil society.
What is true of the so-called coin is not so for the technology to which crypto-currencies have given rise. The technology of ‘trust-less transfer’ is very interesting and it is quite possible (or even likely) that it will become a disruptive technology for many financial intermediaries in the future. The idea of eliminating the need for a trusted third party in finance is revolutionary—the world of finance has never faced such a technological innovation that questions the need for intermediaries and the huge share of earnings in the economy that they appropriate for this role. Given that the trust-less transfer of financial quantities is already a proven technology, it is only a matter of time before it encroaches on business models of banks, credit card businesses, monetary transfers and the trading of assets.
For the policy maker the lesson is clear: permit the development of the trust-less transfer technology with appropriate oversight, but shine sunlight on the dark aspects of the virtual coins. In this respect the working paper noted that the Ripple protocol, which works via a network of servers, is an example or a system that facilitates regulation and improved efficiency. All Ripple transactions appear to be verified by a decentralised computer network, using Ripple’s open source protocol, and recorded in a shared ledger that is a constantly updated database of Ripple accounts and transactions. This sort of approach is quite suitable for regulatory perusal.